Welcome to CanadianHedgeWatch.com
Saturday, December 4, 2021

Change Ahead for Hedge Funds

Date: Monday, December 22, 2008
Author: Richard Beales, New York Times

Hedge funds have suffered a shakeout in 2008. The average hedge fund fell almost 20 percent, according to Hedge Fund Research. No fund has yet required a bailout. But many wonít be around in the new year, and those that have survived are battered and bruised. Hedge fund managers must accept that the industry wonít be quite the same again. Here are six changes they need to prepare for:

Liquidity is the new watchword. Like investment banks, hedge funds didnít think much about the structure of their financing during the boom times. But a flood of redemption requests in late 2008, just as they were struggling with illiquid markets and scarce credit, caught them out. Many hedge funds annoyed their investors by blocking withdrawals. In the future, funds that invest in illiquid assets will need to lock in their investors for longer. And those wishing to give investors regular access to their money will have to focus on liquid markets.

Fees will face greater scrutiny. The archetypal hedge fund charges 2 percent of assets and skims off 20 percent of investment gains, the longstanding ď2-and-20Ē structure. But some funds have had to offer breaks on fees lately to persuade investors not to take their money out. Investors will be more selective and are likely to put downward pressure on fees. All the same, it is probably too soon to sound a Last Post bugle call for 2 and 20.

High water marks will blur. If hedge managers lose money, they normally have to get the fund back up to its previous high for each investor, the so-called high water mark, before the investor has to pay any more performance fees. Broadly speaking, a fund that is down 20 percent from its peak and has a standard high water mark mechanism would need to deliver returns of 25 percent before getting back to its high water mark and earning performance fees again on further gains.

That prospect is daunting. It can leave hedge funds short of cash and their employees wondering where their bonuses will come from. Some managers will throw in the towel. This is why some already use a modified mechanism allowing them to earn reduced performance fees on gains even before they have recouped earlier losses in full. Expect more funds to adopt similar policies.

Regulation will intensify. Many hedge funds, including big names like the Citadel Investment Group, have had a dismal 2008. But unlike the banking sector, they havenít needed bailouts. That doesnít, however, mean hedge funds will escape tighter regulation. Big losses, excess leverage, unexpected curbs on investor withdrawals, and the impact of short-selling on fragile markets make hedge funds easy targets for a crackdown.

Regulators also missed warning signs surrounding Bernard Madoff, who is accused of running a Ponzi scheme that cost investors as much as $50 billion. His investment operation appeared like a hedge fund in that it was private and he purportedly traded options as well as stocks. Watchdogs and investors will, therefore, share a desire for greater disclosure, so long as it is meaningful. The challenge will be in writing sensible regulations that can be applied across a diverse industry.

Concentration will accelerate. Consolidation among hedge funds was under way before the pain of 2008. Hedge funds are set to start the new year managing little more than half the nearly $2 trillion of investor money they held earlier in 2008. Only a handful of top performers ó like Paulson & Company, which oversees $36 billion ó are bigger than a year ago. Smaller firms, many of which have lost money and become smaller still, will be vulnerable to closure and consolidation. Funds under management will become increasingly concentrated among larger hedge funds, which are favored by institutional investors and in some cases have achieved better investment performance than their rivals.

Unleveraged returns should improve. The credit boom allowed funds to prosper even if their investment strategy was simply to use borrowed money to amplify tiny returns. But a smaller hedge-fund industry operating in a deleveraged financial world should be able to find more opportunities to make decent returns without exploiting leverage.

Thatís another way of saying that after a rotten year, stable and committed hedge funds should be able to do well again. Thatís cold comfort for those who have lost big. But it suggests that some in the industry will live to fight another day. RICHARD BEALES